Comparing the Pros and Cons of Opportunity Zones and 1031 Exchange
After the Trump administration signed into law the Tax Cuts and Jobs Act of 2017, America’s real estate community was abuzz over the provision allowing for Qualified Opportunity Zone investments.
In particular, the 1031 exchange community took notice. This is because Opportunity Zones promised to complement — or even replace — traditional tax deferral strategies using I.R.C. section 1031.
Traditional 1031 strategies maintain critical advantages over Opportunity Zone investments. Unless further refined, it is very likely that 1031 exchanges will continue to see the bulk of deferral activity.
Opportunity Zones do carry the potential to help different investors under different circumstances.
Opportunity Zones Explained In 2 Minutes
In a nutshell, the new O-Zone law is an offshoot of older concepts (“Economic Freedom Zones” for a recent example) that relax taxes and regulations in economically depressed regions.
Specifically, Section 1400Z-1 of the Tax Cuts and Jobs Act allowed governors of each U.S. state and territory to nominate poorer areas in their respective regions as “Qualified Opportunity Zones.”
By the summer of 2018, some 9,000 zones (nearly 1/8 of the country) received the QOZ designation.
In the very next section (1400Z-2), the Act offered three tax breaks for potential investors in QOZs.
- Defer capital gains taxes temporarily, so long as the taxpayer reinvests the gains into a Qualified Opportunity Fund (QOF).
- Partially exempt the deferred gains if the investor meets certain holding periods in their QOF.
- Exempt 100% of capital gain during the QOF period if the taxpayer holds an investment in QOF for 10+ years.
Similarities for 1031 Exchange versus Opportunity Zone
At first glance, Opportunity Zone regulations sound a bit like 1031 exchanges. Consider the following rules about qualifying for tax deferral.
- Taxpayers have 180 days to reinvest their capital gains into a QOF or 1031 exchange.
- Taxpayers can continue deferral across multiple sales, provided that they keep rolling the net proceeds into other qualified investments. (Although, under current law, QOF tax benefits go away after 2026).
- Potential for substantial improvement and development in 1031 (using construction exchanges) and QOF (all investments must meet the “substantial improvements” requirement; we explore this later).
- Taxpayers face significant restrictions on transactions involving related parties.
- Any taxpayer facing capital gains tax on real property can use a 1031 exchange or QOF strategy; in both cases, S-corporations face added restrictions.
Which Is Better for Investors?
This is a complicated question. The closest shorthand is “1031 exchanges are probably better for most investors most of the time.”
Let’s qualify that a bit.
After their announcement, QOZs looked like a viable improvement over 1031 exchanges. After all, QOZs only require taxpayers to reinvest their gains; 1031 exchanges, by contrast, require reinvestment of all equity and sales price. QOZs don’t require the use of a Qualified Intermediary. Most tantalizing, a QOF offers the potential for significant tax exclusion, not just deferral.
The story changed on October 19, 2018 with the first set of IRS guidance for Opportunity Zones. The second set of guidance came out on April 17, 2019. With the rules more fleshed out, our analysis can be more definitive.
Here are some quick advantages for each strategy.
Advantages for Section 1031
- Indefinite deferral (rather than ending after 2026 taxes)
- Critical for long-term business and estate planning.
- Section 1031 allows for “boot netting”
- QOFs will be very difficult for real estate investors with more debt than basis in an asset.
- QOFs face more severe geographic restrictions
- Section 1031 allows for deferral of state and local taxes
- Investors in QOZs residing in non-conforming states may still face state and local taxation.
- No “original use” or “substantial improvement” requirements for Section 1031
- It appears that the original use of a property in a QOZ must start with the Opportunity Fund; existing buildings used for existing purposes don’t qualify.
- The lone exception to the “original use” rule is for property that QOF sponsors “substantially improve”. Substantial improvement means spending as much money on improvements as the QOF’s original basis.
- The new guidance on April 17, 2019 did create room for the purchase of raw land in a QOF. However, that land must be used to conduct a trade or business.
- “Turnkey” assets are not eligible for investment in a QOZ through a QOF.
- QOF sponsors often lack proper vetting. It will take some time before it is easy to determine which sponsors can be trusted and charge reasonable fees.
- There are likely to be many learning curves for career investors that must suddenly act as developers for the first time.
- Opportunity Zone investments do not allow for deferral on ordinary income recapture; 1031 investments do.
- By and large, investors retain more control over their property in a 1031.
- Estate planning through 1031 exchange is much stronger than QOF.
- Inherited investments inside a QOF do not receive a stepped-up basis to market value.
- Indefinite deferral (rather than ending after 2026 taxes)
Advantages for Opportunity Zones
- Potential for partial exemption on prior deferred gains
- Applies to QOF investments made before December 31, 2019, and held for 7+ years.
- Potential for full exclusion of gains during the QOZ investment period
- Applies to QOF investments held (within one or across multiple QOZ assets) for 10+ years up to the payment of 2048 taxes.
- Easier for development (improvements and construction)
- Many QOFs have a 2-5 year improvement window.
- Construction 1031 exchanges are difficult and likely to become more difficult.
- QOFs only require reinvestment of the gains to qualify for deferral
- Allow for investment via cash or property
- The ability to contribute property and receive a partnership interest position in the QOF depends on the basis being equal to gain deferred.
- Ability to defer gains on non-property assets
- Wider range of acceptable property types
- The ability of the taxpayer to directly possess sale proceeds
- Section 1031 does not allow for direct receipt without triggering taxes.
- Potential for partial exemption on prior deferred gains
Why Section 1031 Is Better (Most of the Time)
Major downsides exist in the QOZ regulations that, for many investors, simply remove them as a viable option.
First, QOF investors must invest as a partnership or part of a corporation (S-corp or C-corp). Pass-through LLCs do not qualify. Second, benefits go away if you don’t hold a QOF investment for the long holding periods (5-, 7-, or 10+ years). In many cases, QOFs are less liquid than 1031 assets — cashing out of a QOF may not be straightforward.
That’s a lot of control to give up.
Moreover, limitations on replacing indebtedness in a QOF really limits the use of financial leverage. Indebtedness in a QOF can only be replaced against the equity interest, not against the underlying asset itself.
Finally, we have the “original use” and “substantial improvement” requirements.
In practical terms, these requirements effectively limit Opportunity Zone investments to (a) new construction or (b) redevelopment projects. Many real estate investors don’t have the expertise or inclination to engage in development.
The Politics of Qualified Opportunity Zones
QOZs and QOFs exist with much greater uncertainty than 1031 exchanges. Some of this is a byproduct of the scheme’s relative youth. These simply haven’t been around long enough for the kinks to work out.
Something like 95% of 1031 exchange law is settled and understood. There are always changes and challenges on the margin, but 1031s have been with us for nearly 100 years.
Even after two rounds of guidance, perhaps only 60-70% of Opportunity Zone law appears set in stone.
Also, investors shouldn’t ignore the politics surrounding the new QOZ law.
Since the Tax Cut and Jobs Act was passed by a Republican Congress and White House, many Democrats started out against it and remain unhappy with it. These Opportunity Zones have already been labeled as tax breaks for wealthy investors and corporations.
If the GOP loses a presidential election in 2020 or 2024, the potential exists for QOF investors to be left holding the bag after the law is repealed or rewritten.
Using both 1031 Exchanges and Opportunity Zones?
Clever investors may ask themselves “Can’t I combined 1031 exchange and QOZ strategies?”
In a way, yes.
But not necessarily in the way you might hope.
Internal 1031 Exchange In QOZ
Any property sold in a QOF prior to the 10-year exemption period will trigger normal income tax consequences. As the new guidance in April 2019 makes clear, investors may trade one QOF interest for another (with some restrictions).
You could even perform an internal 1031 exchange into a new QOZ opportunity. Given the requirements for substantial improvement or original use, this may need to be a safe harbor or non-safe harbor construction exchange.
(Alternatively, the sponsor could do a capital call and receive the development equity after an internal exchange closes.)
You cannot do a 1031 exchange from a non-OZ property into a QOF.
Contribute 1031 Property to Offset Other Capital Gain
This is a little less understood and its effects would need to be adjudicated by some relevant authority.
However, it is likely possible to (a) close on a Section 1031 exchange, then (b) contribute the property to a Qualified Opportunity Fund for a partnership interest.
In theory, the completed 1031 would allow for the deferral of taxes on the real relinquished property. If the same taxpayer faces large capital gains on another asset (even one that is not real property), the taxpayer could contribute his or her replacement property from the recently completed 1031 into a QOF rather than the non-1031 sale asset.
The result would be a mixed investment and may face IRS scrutiny.
Are Opportunity Zones a “Bailout” for a Failed 1031?
Imagine that you start a 1031 exchange.
- You sell the relinquished property for $1.5M with $500K in capital gains.
- After-sale, you escrow $800K in proceeds through a QI.
- You identify three replacement properties within 45 days, but can’t close on any by Day 180.
- On Day 181, the exchange fails and you receive your $800K in proceeds from QI.
Can you turn around and invest the $500K in gains into a QOF? Of course, this wouldn’t relieve you of the depreciation recapture taxes from your sale. But $500K in gains represents a heavy tax bill.
Unfortunately, the likely answer is “No.”
This is because Treasury Reg. 1.1031(k)-(1)(g)(6) mandates that investors must require their replacement property(ies) or wait until Day 181 to receive 1031 exchange proceeds.
Opportunity Zone regulations limit the reinvestment period to 180 days between the sale of the taxable asset and the investment into the Qualified Opportunity Fund. The money received on Day 181 is ineligible for the QOF.
It appears that taxpayers have two alternatives.
- If you do not identify any replacement properties, you may request that your QI release your $800K in proceeds to you on Day 46. You have until Day 180 to invest the $500K in gains (not all net proceeds) into the QOF.
- Enter into a non-safe harbor 1031 exchange agreement that does not include the (g)(6) limitations. Anytime between Day 1 and Day 180, demand your proceeds back from the escrow account provider (potentially a QI) and divert the $500K in gains to a QOF.
Option #2 is not a good idea.
The IRS treats differently any 1031 exchange entered into outside of the QI safe harbor regulations. If you fail the 1031, you may not only face your full tax liability but also be subject to extra penalties and interest payments.
The new proposed regulations for Opportunity Zones clarified many issues and, on net, made QOZs and QOFs more attractive for investors.
Unfortunately, the IRS still needs to provide further guidance on many, many more issues than this article addresses. In fact, the entire Tax Cuts and Jobs Act still presents plenty of inconsistency and vaguery. We don’t know when QOF sponsors or investors can expect stable regulations.
For more information on 1031 exchanges or opportunity zones, please contact our office. A specialist will review your tax strategy with you.
This article does not constitute legal or tax advice.